Thursday, October 23, 2014

From a consumer standpoint I might not really appreciate insurance companies. After all, it seems like the money I spend on my premiums just goes into a black hole, never to be seen from again. I rarely initiate claims, and would prefer to keep it that way, as that means some kind of tragedy has likely befallen me.

However, from the perspective of an investor I quite like insurance companies. They basically collect premiums up front and get to invest that capital in the interim until you make a claim against your policy. It’s a low-cost source of capital, called the float, and these companies gets to keep any gains (and losses, for that matter) they reap on other people’s money. So prudent underwriting allows an insurance company to a earn profit on the premiums they charge, while prudent management of the investment portfolio also allows profit there as well.

It’s obviously a fantastic and easily understood business model, which is probably why Warren Buffett is such a fan of insurance companies. His investigation into GEICO led to him penning an article way back in 1951, at age 21, titled “The Security I Like Best” as can be seen in its reproduced form in Berkshire Hathaway Inc.’s (BRK.B) 2005 annual report on page 24.

I currently am invested in just one insurance company – Aflac Incorporated (AFL). Aflac is a supplemental health and life insurance company, and it’s been a tremendous holding for me so far. 31 consecutive years of dividend raises, with another raise due up in a month. I was fortunate enough to load up on Aflac back in 2011 when it was a lot cheaper due to fears over its investment portfolio being too heavily allocated to sovereign debt in risky countries and of course the Fukushima disaster. There are still fears over its exposure to the Japanese bond market and its heavy reliance on the Yen. I’m not concerned.

However, I am content with my 100 shares. Furthermore, I’d like to diversify my insurance holdings with an insurer that offers property and casualty products and services. This would allow me additional financial exposure from a different angle. As such, I’m currently investigating two insurers for a possible addition to the Freedom Fund. Both of the below companies saw record performances in 2013, and both may very well see lower earnings over the next couple fiscal years. But they also appear fairly appealing at today’s prices, considering their long-term growth potential, conservative underwriting, and international exposure.

Travelers Companies Inc. (TRV)

Travelers Companies Inc. is a holding company. Through its subsidiaries it provides commercial and personal property and casualty insurance products and services to individuals, businesses, government units, and associations. They operate primarily in the US, but also have operations in Canada, Ireland, and the UK.

I actually just took a good look at Travelers for Daily Trade Alert and concluded that the stock is undervalued, possibly vastly so. I love the growth rate of the company; earnings per share grew at a compound annual rate of 22.83% over the last decade, which is obviously impressive. The company routinely buys back significant portions of its stock, and since 2006 has cut its share count in more than half. That explains at least partly why there is such a difference between top line and bottom line growth, as revenue has grown at a slower compound annual rate of just 1.49% over this same time frame.

TRV appears to take pride in its conservative underwriting, which doesn’t sacrifice quality for growth. And they carry that same conservative attitude over to their $73 billion investment portfolio, as it’s mostly invested in US government, municipal, corporate, and US agency mortgage-backed bonds. Rising rates could help TRV’s profitability here, along with other insurance companies, including the one below.

The company sports 10 consecutive years of dividend growth, raising the dividend annually since their merger with The St. Paul Companies Inc in 2004. They’ve increased the dividend by a compound annual rate of 9.5% over the last decade. Meanwhile, the stock’s entry yield stands at 2.35%. And the payout ratio remains really low, at just 22.2%, so there’s plenty of room for future dividend raises going forward.

The balance sheet is solid, and so is profitability. Operating margin has averaged 11.34% over the last five years. Return on equity has averaged 11.22% over the same time period. The yield leaves a bit to be desired, but I really like the way this company is run. Shares appear cheap here, with a price-to-earnings ratio of just 9.45. This remains an interesting opportunity, in my view, to pick up a $31+ billion insurer at what appears to be a pretty attractive valuation. I’m currently strongly considering initiating a position in this company right now.

The Chubb Corporation (CB)

The Chubb Corporation is a holding company that provides, through its subsidiaries, property and casualty insurance to a variety of clients throughout the US and internationally.

Chubb is probably a bit unloved, but it’s long been a fantastic company. Looking through their financial metrics, one can see that they are obviously quite conservative in their operations. Fiscal year 2013 was just a blockbuster year for the company in terms of earnings per share and percentage of premium dollars spent on claims and expenses.

Earnings per share grew at a CAGR of 9.45% from fiscal years 2004-2013, which spans the last decade. Meanwhile, revenue compounded at a 0.40% over this same time frame. You see the lack of top line growth, but net income has grown fairly substantially due in large part to rather aggressive share repurchasing by the company. The great thing with their share repurchases is that, like Travelers, they were consistently buying back shares through the recession, which supercharged the buyback program’s ability to return value to shareholders.

The company has an impressive record of dividend growth, which might be surprising to any who do not follow this company. The insurer has grown its dividend for the last 32 consecutive years, which is really solid, especially considering the inherent risk in insurance. This speaks further to their prudence and conservative nature. The yield on shares right now, also like Travelers, leaves a bit to be desired, as this stock offers a yield of just 2.18%. However, we have another low payout ratio, at 24.5%. So one would naturally assume dividend growth will continue far into the future. Chubb boasts a 10-year dividend growth rate of 9.2%, and I see no reason this kind of rate won’t continue looking forward.

Like Travelers, the balance sheet leverage is quite low, but operating margin and return on equity bests TRV. Operating margin has averaged 14.73% over the past five years. Return on equity meanwhile has averaged 12.36% during the same time frame. However, shares appear quite a bit pricier here, with a P/E ratio of 11.21. A lot to like, but I’d like it a lot more if it were a bit cheaper. However, CB remains high on my watch list.

Full Disclosure: Long AFL.

What do you think? Interested in either insurer right now? Why or why not?

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